Speculation was rife in the five years leading up to the 2022 market correction. Despite a mini-economic slowdown in late 2018 and the 2020 COVID crash, speculative activity was on par with the excesses leading up to the 2008 Global Financial Crisis (GFC). Specifically, the percentage of negative return months over a five-year period were at record lows of around 25% versus the long-term average of 36%. During those periods, ‘buying the dip’ strategies generated excess returns without much risk.
Source: Iress Vertium
However, just like night follows day, market extremes are cyclical. With market volatility increasing over the last couple of years, from depressed levels vs the long-term average, we are now at an important juncture. Will market volatility continue to rise further (hard landing), remain steady at current levels (soft landing), or reverse and begin to fall (strong recovery)?
At the moment, the market seems very confused. At one extreme, investors expect rising bond prices (lower bond yields). At the other extreme, investors are extremely underweight bond proxies such as REITs. Both parties cannot be correct given the correlation between bonds and bond proxies.
Source: Bank of America Fund Manager Survey
Another confusing dynamic is the breakdown in relationship between bankruptcies and credit spreads (credit risk premiums expected on top of the risk-free rate) in the United States. Historically, there is a tight relationship because rising bankruptcies occur when the corporate sector is under stress, leading to rising credit spreads. However, for the first time in history, credit markets are not pricing in the underlying weakness in the economy.
Tame credit markets have mirrored falling corporate interest payments despite rising interest rates. Typically, rising rates and corporate interest payments go hand in hand, but the current divergence has never occurred before. Is the monetary system broken and is this the new normal?
These perplexing anomalies can be explained by a 1 in 100-year event that occurred three years ago. The worldwide COVID lockdowns made everyone panic. Central Banks panicked by aggressively lowering interest rates and the US Federal Reserve embarked on its fourth Quantitative Easing program since the GFC to keep debt markets liquid. Corporations also panicked, taking advantage of extremely low rates to refinance as much of their debt into the future as possible.
Due to the large-scale refinancings that occurred in 2020, corporations locked in debt at artificially low rates resulting in very low interest payments, despite the fastest pace of interest rate increases in history. Without the need to refinance over the last couple of years, credit spreads remained benign. However, corporate debt has not disappeared as US corporate debt to GDP is at 77%. The 2020 panic has resulted in a looming wave of debt refinancings over the next few years.
When corporations refinance en masse, credit spreads will likely expand. It is just demand and supply at work. When this occurs interest payments will soar from very low levels and will likely pressure corporate profitability. Under this scenario, there are several market implications and one of them is rising equity market volatility.
In conclusion, financial market anomalies are confusing investors. Most market commentators are pointing to a soft landing for equity markets as the United States has averted a recession over the last year. However, an important crossroad has been reached. The looming corporate debt refinancings on the horizon could change the market’s volatility profile. When the liquidity tide goes out, corporate profitability could be left exposed. Vertium’s low beta strategy is well positioned if market volatility rears its head again.